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The Power of Omission- The Expert Take

Although it sounds contradictory, President Peña Nieto considers the reform of the energy sector to be so important that he is willing to classify it as a non-strategic sector.

On August 11th, President Enrique Peña Nieto sent his energy reform proposal to Congress, despite the fact that he did not have the full support for the reform from all parties included in the “Pacto por Mexico.” The proposal, as he had promised, is transformative, suggesting several significant changes to the Constitution.

The reform, which will be discussed in the Senate this October, seeks to amend articles 27 and 28 of the Mexican constitution. Although it has not been recognized as such, the President's proposal is revolutionary not because of the language it adds, but rather, because of the language it omits. The reform erases the word "contracts" in the phrase "For oil and solid, liquid or gaseous hydrocarbons or radioactive minerals, no concessions or contracts shall be granted" found in Article 27. From Article 28, it omits the words “oil and other hydrocarbons, basic petrochemicals, electricity" from the list of strategic areas.

By proposing to eliminate these words and phrases from the law, President Peña Nieto has crossed the Rubicon, laying the foundation for a reform devoted to transforming the energy sector. These changes have the potential to convert the sector into a competitive energy market that promotes the country's industrialization.

The President's proposal was not made ​​in a vacuum, but rather it took into consideration the energy and industrial revolution currently taking place in the United States and Canada. It was not anticipated that technological innovations in shale gas and oil exploration would result in a decline in gas prices, and allow for the possibility of the United States becoming an oil surplus country in the medium term. The country that could benefit the most from this industrial resurgence in the United States (driven by the cheapest natural gas in the world) is Mexico. However, this will not happen without a competitive energy market that ensures the same conditions exist in Mexico and in the rest of North America. The choice is clear: without energy reform Mexico would not only miss the opportunity to modernize the energy sector, it also would condemn the rest of the industry to compete globally with a tied hand.

The reform proposal is revolutionary because of its legal construction. By taking out the word “contracts” from Article 27 and the energy sector from the strategic areas in article 28, the proposal sets new conditions to the secondary laws, meaning that Pemex and CFE will no longer be the only companies able to exploit those sectors. That is, President Peña Nieto considers the reform of the energy sector to be so important that he is willing to classify it as a non-strategic sector. It is important to note that by removing hydrocarbonexploitation from the list of strategic areas, conditions set in Article 25, which mandates: “The public sector shall have power to manage in, an exclusive way, the strategic areas established as such by Article 28, paragraph four of this Constitution. The Federal government shall always keep the property and full control over the agencies created therein” no longer apply.

Under the reform, the energy sector, considered to be non-strategic, would be fully subject to the Federal Law of Economic Competition. The reform would also allow the participation of public or private corporations or public-private partnerships. Under such conditions, if the State wants to develop a new oil reservoir or gas field, it may assign its exploration to Pemex, to Pemex and a partner, or to a third private party, foreign or domestic. A similar phenomenon would occur in the case of electric power.

Creating options is at the heart of the President's proposal. If the reform is approved, Pemex will no longer exclusively decide which field to explore, or how to do it. And yet, Pemex can always compete to develop new fields, either alone or with a partner. This is what guarantees the state the opportunity to maximize its oil rent.

The constitutional amendment does not specify the type of contracts that may be signed with Pemex or others. There are three possibilities: there could be Services contracts (which already exist but are insufficient), Profit Sharing Contracts (preferred by President Peña Nieto) and Production Sharing Contracts (preferred by the major oil companies). The difference between the last two types of contract lies in the first-hand sale of the extracted oil.

In the case of profit sharing contracts, there are three options to dispose of extracted petroleum: the first two do not maximize the selling price of oil and revenues, but the third does. In the first case, the oil would be delivered to Pemex, even if it is not extracted by Pemex, for the final sale. In the second, the Mexican State would select a trading company outside Pemex to carry out the sale. In the third, the contracting oil company would sell the product at the maximum possible market price on behalf of the Mexican state. The incentive for the contractor is to maximize the sale price, and in turn, profits. For this reason, the last option erases the difference between profit sharing contracts and production-sharing contracts.

The arguments against the reform do not hold: the Mexican government could always choose Pemex if it offered the best alternative to explore and exploit the deposits over which the Nation has full and inalienable ownership. In fact, it is only by passing the reform that it will be possible to fulfill the mandate of Article 134 of the Constitution: “to ensure the State the best available terms”. That is, if Pemex does not offer the best conditions and a third party does, it would be appropriate to use the latter. Pemex will win all the contracts that it is the best option for.

Since President Peña Nieto has spent political capital in proposing a Constitutional amendment, he must now push the reform’s approval. The president should also seek to ensure that all implementing laws are expansive enough to fully allow the constitutional reforms to bear fruit.

How shouldthe other political parties vote?

The PAN should join the proposal in order to make some gains in the electoral and energy sectors. On the energy front, the reform could ensure the strengthening of both the National Hydrocarbons Commission and the Energy Regulatory Commission in order to have strong regulatory bodies that can promote competition and protect the county’s interests. The PAN also could insist on the formalization of an oil-revenue sovereign fund. Yet, it would be a mistake to insist that these three bodies be constitutionally autonomous. This has been done in the case of the IFETEL and COFECO. In the energy sector, it would be a mistake. Contrary to popular belief, autonomy implies less accountability because there is no system of checks and balances in place.

Finally, the PAN should consider that there is no difference between its proposal, which allows concessions, and the President’s one, which only allows profit sharing contracts. The Transitory Article 10 proposed by the PAN states: “Under the concessions system for the exploration and exploitation of hydrocarbons, Pemex and the referred operators in Article 28 of this Constitution shall be subject to a competitive bidding process by which they recognize the national ownership of hydrocarbons”. Thus, the apparent difference between contract and concession does not exist.

Despite impassioned arguments by Cuauhtémoc Cardenas, the PRD should also support the proposal of Los Pinos, for two reasons. The first one is that the main beneficiary of the reform would be Pemex. Currently, the company is caught in a bind – in an attempt to be “strategic”, it has a limited capacity to acquire service contracts and is subject to heavy regulation and government bureaucracy. The main result has been that Pemex is an administrator of services contracts with costs that are distorted in order to mask profits and get few results amid the absence of incentives for success. Under this scheme, the technological expertise of Pemex will inexorably erode.

Furthermore, Pemex would benefit from the most liberal contracts scheme, which will allow the state to finance investment and expansion in the same way as competitors. If profit sharing contracts are written so that future profits cannot be ensured or leveraged, Pemex wil not be competitive, as it would not be able to raise resources in the market.

The second reason why the PRD should support the proposal has to do with the PRD’s participation in the policy arena. Contributing to the energy reform would allow the PRD to continue to actively participate in the Pact for Mexico and to promote its social agenda in that context. The PRD’s participation could help the Federal District to become the state of Mexico City.

The main danger the reform proposal faces is that key omissions to the law are compromised as a result of the broadest possible consensus. In this scenario, the contract modalities for strategic areas would be included in the Constitution. If this occurs, the reform will not differ from previous reforms and the country will be condemned with little growth.